Bitcoin And Blockchain’s Pivotal Moment – How We Got Here

Analyst Note

Bitcoin and blockchain have been some of the most exciting yet misunderstood technologies to emerge in the last decade. Investors have pumped some $1.8 billion into equity investments in companies utilizing the technology since 2013. This doesn’t include the individuals and groups pouring resources into the technology’s supporting hardware, which in aggregate holds 8x the processing power of the world’s 500 fastest supercomputers. Meanwhile, every bank, brokerage house and multinational worth its salt has issued a press release announcing one multimillion dollar partnership or another to explore the implications for their business.

This is a pivotal moment for blockchain. Institutional investors have wagered that the technology will more than pay off by revolutionizing global payments, securities clearing and financial services, with

further wide-reaching implications for monetizing media and content distribution, the sharing economy and IoT. While recent high-profile missteps have cast a shadow over the industry, its continued scaling only goes to illustrate how rapidly the technology has burgeoned thanks to outsized consumer and enterprise interest.

Evan B. Morris

How We Got Here

[drizzle]Many of the emerging use cases of blockchain are still highly abstract. Examining the disruptive potential of a new technology requires first exploring the historical process and pressures that created the status quo. Above all, payment systems must insure that each unit of value is rightfully held by the spender so that each unit of currency can only be spent once. This is referred to as the double spend problem. Historically, this was solved with intrinsically valuable metallic coins, and later with bank-issued paper currency that was difficult to counterfeit. In order to facilitate overseas trade prior to electronic long-distance communication, the Medicis developed double-entry accounting listing two columns for assets and liabilities. For each credited account, another account would be debited so that each transaction took place in a closed system. Updated ledgers were copied and distributed to far-flung branches.

Bankers kept track of deposits and liabilities using double ledger accounts on each other’s books since banknotes were backed by gold deposits. These metallic reserves were difficult to transport, so banks needed a way to keep track of who owned what. This decentralized system had other inefficiencies. Having multiple banks issue their own banknotes opened up the possibility of fraud due to the sheer diversity of paper bills in circulation. Since consumers had to be sensitive to perceived solvency, this created a higher likelihood of bank runs. Central banks emerged to take over and standardize banknote issuance and further centralize the multilateral banking system, as each constituent bank now had an account with the central bank.

As we will examine later, blockchain has the potential to bring heightened transparency to asset ownership. Tracking ownership of alternative assets has always been opaque, in some ways even more so than gold or currency accounts. While stock certificates tracking claims on assets were hard to forge even in the days before high-quality printing, transactions—and thus overall ownership—could only be tracked through a central broker-dealer or clearinghouse. Cap tables listing equity ownership and creditors were only cleaned up in the case of a liquidity event such as a merger or acquisition. This lack of transparency makes events such as bankruptcy proceedings very costly and tedious.

Central banks became even more essential to providing liquidity and issuing standardized paper currency once fractional reserve banking emerged, as banks only kept a small portion of capital on hand as deposits. However, central banks gradually did away with the gold standard, as the Keynesian doctrine of running deficits in lean times and surpluses in good times proved difficult to implement during the Great Depression and World Wars.

In a democratic society—even if the central bank is independent—there is a bias toward more expansionary/inflationary monetary policy. In the current macro environment, central banks and governments have coordinated to promote inflation through asset purchases and perpetual budget deficits, which increase the money supply every year and dilute the value of currency over time. In addition to what we see in the developed world, the limitations of government-backed currencies as a store of value have been proven time and time again, such as in hyper-inflationary episodes in Germany, Zimbabwe and every few years in Latin America. Bitcoin exhibits opposite (deflationary) properties, as you will see in later sections.

Thus far, we’ve examined the gaps in historical financial infrastructure that have helped support bitcoin/blockchain’s importance and rise. Yet, similar to many other emerging tech, the invention of the internet has played a pivotal role in bitcoin/blockchain’s growth. The development of the internet, however, did not initially address any of the issues with the existing financial infrastructure, in part due to the reticence of institutions to relinquish tight control over centralized ownership databases. Even so, conducting fast and secure online payments was one of the obvious use cases of the internet.

However, developers took some time to fix the double spend problem—the issue of ensuring each currency unit is only spent once. Initial online payment platforms often took months to settle transactions in order to jump through many hoops including fraud prevention. David Chaum patented an early online payments system called DigiCash that operated similarly to how airlines now process credit cards in-flight. Payer and receiver exchange serial numbers and, once electronically connected to central digital ledger, the transaction could be verified. The system enabled much smaller unit payments than was cost effective with existing credit card payment networks, and had a much higher level of security. DigiCash filed for Chapter 11 bankruptcy in 1998 but, to be clear, its failure did not stem from issues driven by its technology being poorly adopted. The company offered a secure payment system that solved the double spend problem, the greatest issue bitcoin strives to solve, yet unfortunately, poor management at the executive level left many promising projects half-completed.

A confluence of seemingly unrelated early internet technologies enabled the development of cryptocurrencies. One early method to solve the ubiquitous problem of email spam was the forcing of a sender to complete a digital puzzle in order to send a message. Although the required computational power was insignificant to a home or business user, a spambot sending thousands of unsolicited messages would be cut at the knees. Since many forms of hacking require “brute force” to exploit systems, a built-in speed bump like solving a puzzle represents a considerable security upgrade and, as we explain later, is an essential aspect of blockchain technology. The 1990s also saw the development of anonymous browsing on the Tor network developed by research labs associated with the US military. Tor encrypts data and sends it through a network of peer nodes where it becomes impossible to track to any one point. This allows for near anonymization, as traffic becomes broadly distributed across the entire network. Rather than rely on one chain of centralized servers, traffic is requested and routed across whomever has available resources to handle the bandwidth. While each of these technologies has had varied standalone impact, the confluence of these and other tech has played a pivotal role in the emergence of blockchain.

How Bitcoin Works

In 2009, “Satoshi Nakamoto” pseudonymously released the paper “Bitcoin: A Peer-to-Peer Electronic Cash System.” Satoshi envisioned bitcoin as a distributed digital payment system that